Modern Macroeconomics Is Built around the “Level” of Demand, But Before Keynes the “Structure” of Demand Mattered Most

Recessions occur because goods and services are produced that cannot be sold for prices that cover their costs. There are countless possible reasons why and how such mistaken production decisions occur. But when all is said and done, the causes of recessions are structural. They are the consequence of structural imbalances that result from errors in production decisions, not the fall in output and demand that necessarily follows.

This cannot be emphasized enough. Modern macroeconomics is built around the notion of the level of demand, while before Keynes recessions were understood in terms of the structure of demand. The difference could not be more profound. To policy-makers today, the basic issue in analysing recessions is whether there is enough demand in total. To economists before Keynes, the central issue was to explain why markets had become unbalanced.

In modern economic theory, rising and falling levels of spending are for all practical purposes what matters. That is why increasing public spending and adding to deficits are seen as an intrinsic part of the solution, not as the additional problem such spending actually is.

Missing in modern economic debates is an understanding of the importance of structure: the parts of the economy must fit together. What’s missing is an understanding that if the entire economic apparatus goes out of sync, recession is the result and recession will persist until all the parts once again begin to mesh.

—Steven Kates, “The Crisis in Economic Theory: The Dead End of Keynesian Economics,” in Macroeconomic Theory and its Failings: Alternative Perspectives on the Global Financial Crisis, ed. Steven Kates (Cheltenham, UK: Edward Elgar Publishing, 2010), 119-120.

The Austrian School Rejects the Fundamental Assumptions of Modern Macroeconomics

In neoclassical analyses capital is normally treated as a homogeneous aggregate; it is ‘K’ in various models. This is a crucial error from an Austrian perspective. Because capital is, for the Austrians, always embodied in specific goods, it cannot be treated as an undifferentiated mass. Entrepreneurs purchase inputs or build machines that are designed for specific purposes. They cannot be costlessly redeployed to an infinite number of other uses the way the homogeneous conception of capital might suggest. Austrians see capital as heterogeneous and having a limited number of specific uses (Lachmann, 1978 [1956]; Kirzner, 1966). The same is true of labor. The skills and knowledge workers have are not appropriate for all potential production processes, thus their human capital can be conceived of as heterogeneous and specific to a limited number of uses.

Capital is not only heterogeneous in this sense, it also might embody error. Given an uncertain future, producers are always making their best guess as to what to produce and how, so the range of capital goods in existence at any moment is likely to embody a variety of entrepreneurial errors. For example, if two producers buy up the inputs to produce a particular kind of running shoe, but the demand is sufficient only for one to be profitable, then the capital of the other has been misallocated. Of course, we cannot know that until the market process unfolds and the one firm’s losses indicate that the value of their final product was not sufficient to cover costs including interest. This point is important because it implies that we cannot just add up the value of existing capital to get some aggregate measure of ‘total capital’. That procedure would be valid only in equilibrium, where we knew that each higher-order good was deployed correctly. We cannot add up existing stocks of capital to get some aggregate. In thinking about capital we must pay attention to both where the capital (and labor) sit in the structure of production and factors that might distort price signals in ways that make it more difficult for firms to synchronize their production with the public’s preferences about consumption.

—Steven Horwitz, “The Microeconomic Foundations of Macroeconomic Disorder: An Austrian Perspective on the Great Recession of 2008,” in Macroeconomic Theory and its Failings: Alternative Perspectives on the Global Financial Crisis, ed. Steven Kates (Cheltenham, UK: Edward Elgar Publishing, 2010), 98-99.